Answers To Roth IRA Conversion Questions From Advisors

How would a flat tax affect the Roth IRA conversion decision? What's a good way to offset income generated by a Roth IRA Conversion? This post answers questions raised by advisors at a recent webinar on tax-efficient investing.

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1.In the unlikely event of a flat tax, what would be the effect on the Roth IRA conversion decision?

To understand the effect of a flat tax on the Roth IRA conversion decision, it is first necessary to understand the Roth conversion decision under current law. If tax rates are the same at the time of conversion and when distributions are made, IRA assets must be used to pay the tax on the conversion and the taxpayer needs to take out at least the required minimum distribution (RMD) each year after retirement, the basic economics of a traditional IRA and a Roth IRA are the same. The following simplified example illustrates this point.

Example 1. Taxpayer (T) has $100 in a traditional IRA. T is currently in the 28% marginal income tax bracket and expects to be in the same bracket in 20 years when IRA distributions begin. The IRA assets are expected to triple in value over this period of time. If T makes a Roth conversion now, T will pay $28 in tax from the IRA, leaving $72. This $72 will grow to $216 in 20 years. T can receive the $216 tax-free at that time, leaving T with $216 after tax. If T elects not to do the conversion, the $100 will grow to $300 in 20 years. T will then pay a tax of $84 on a distribution (.28 x $300), leaving the same $216.

Conversion

No Conversion

Beginning amount

$100

$100

Current tax

28

0

Left after tax

72

100

Value after 20 years (x3)

216

300

Tax payable on distribution

0

84

Net to beneficiaries

$216

$216

If the taxpayer can pay the conversion tax with outside assets (side fund), however, the Roth conversion will produce superior tax results even though the tax rates are the same for the conversion and for the distributions.

Example 2. Assume the same facts as in Example 1, and also that T has $28 in a side fund that can be used to pay the tax on the conversion. Also assume that because it will be invested in taxable investments, the money in the side fund will only grow to 2.5 times its current value at the end of the 20-year period. The after-tax amounts passing to beneficiaries are shown below.

Traditional IRA

IRA

Side Fund

Beginning amount

$100

$28

Current tax

0

0

Left after tax

100

28

Value after 20 years (x3)

300

70

Tax payable on distribution

84

79

Net to beneficiaries

$216

$70

Total net to beneficiaries

$286

Roth IRA Conversion

IRA

Side Fund

Beginning amount

$100

$28

Current tax

0

28

Left after tax

100

0

Value after 20 years (x3)

300

0

Tax payable on distribution

0

0

Net to beneficiaries

$300

$0

Total net to beneficiaries

$300

The $14 advantage of the Roth IRA is due to the different growth rate for the assets inside the IRA (3x) and the taxable growth rate of the taxable account (2.5x).

If the conversion tax can be paid with outside funds, a Roth conversion may be superior to leaving the funds in a traditional IRA even if the applicable income tax rate drops significantly between the time of the conversion and the time distributions are made.

Example 3. Assume the same facts as in Example 2, except that T’s marginal income tax rate drops from 28% at the time of the Roth conversion to 25% at the end of 20 years.

Traditional IRA

IRA

Side Fund

Beginning amount

$100

$28

Current tax

0

0

Left after tax

100

28

Value after 20 years (x3)

300

70

Tax payable on distribution

75

0

Net to beneficiaries

$225

$70

Total net to beneficiaries

$295

Roth IRA Conversion

IRA

Side Fund

Beginning amount

$100

$28

Current tax

0

28

Left after tax

100

0

Value after 20 years (x3)

300

0

Tax payable on distribution

0

0

Net to beneficiaries

$300

$0

Total net to beneficiaries

$300

As the rate drop becomes more substantial, however, the traditional IRA would begin might produce superior tax results.

Example 4. Assume the same facts as in Example 3 except thatT’s marginal tax rate decreases from 28% at the time of conversion to 15% when distributions are made.

Traditional IRA

IRA

Side Fund

Beginning amount

$100

$28

Current tax

0

0

Left after tax

100

28

Value after 20 years (x3)

300

70

Tax payable on distribution

45

0

Net to beneficiaries

$245

$70

Total net to beneficiaries

$325

Roth IRA Conversion

IRA

Side Fund

Beginning amount

$100

$28

Current tax

28

28

Left after tax

72

0

Value after 20 years (x3)

300

0

Tax payable on distribution

0

0

Net to beneficiaries

$300

$0

Total net to beneficiaries

$300

The amounts shown in the charts above represent the total wealth under the two options as of a particular date, before any distributions have been made. If T does not need to take out at least the RMD, slower distributions from the Roth IRA will enable T to accumulate more wealth for heirs. The money can continue to grow tax-deferred in the account, creating an important estate planning advantage for the Roth IRA.

If the U.S. enacts a flat tax, the marginal tax rate for a taxpayer will be the same when the conversion decision is made and when distributions begin. This would simplify the conversion decision, leading to the following conclusions:

If the taxpayer cannot pay the conversion tax with outside funds and will take distributions at least equal to the RMD, converting will be a matter of indifference for the taxpayer.

If the taxpayer has outside funds to pay the tax on the conversion or will not need the full amount of the RMD, converting will always be the better choice.

Leaving the money in the traditional IRA might produce the same economic result as converting, but it will never be better.

Under current law, it might make sense to convert only that portion of a traditional IRA that does not push the taxpayer into a higher tax bracket. With a flat tax, this issue would disappear.

2.Are there any good ways to generate losses to offset income generated by a Roth IRA conversion?

Perhaps the best way to offset income generated by a Roth IRA conversion is with intangible drilling costs (IDCs) associated with oil and gas investments. IDCs are costs of developing a well that will not be part of the final operating well, like clearing ground, draining land, road building, surveying, hauling, repairs, fuel, supplies, and wages. Unlike most costs that must be capitalized over future periods, up to 80 percent of IDCs can be deducted in the current year. Thus, for example, if a taxpayer converts a $160,000 traditional IRA to a Roth IRA, a $200,000 investment in an oil or gas well could offset all of the conversion income.

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